Larry Summers’s Bad Math Is S&P Informed Opinion: Caroline Baum

Aug. 19 (Bloomberg) -- When Standard & Poor’s downgraded
the U.S.’s long-term credit rating from AAA to AA+ on Aug. 5,
Washington went on the offensive.

President Barack Obama’s advisers blasted S&P. The
administration’s friends and allies came out with guns blazing.
The Securities and Exchange Commission is reportedly
scrutinizing S&P’s procedures connected with the downgrade. And
the Senate Banking Committee is said to be pondering an
investigation -- into what exactly, committee members haven’t
said.

None of S&P’s detractors let us forget for one minute that
this is the same S&P that slapped a AAA rating on collateralized
subprime junk during the housing bubble, and that gave Enron
Corp. and WorldCom Inc. investment-grade ratings shortly before
each of them imploded.

What’s more, the U.S. Treasury found a $2 trillion error in
S&P’s analysis, prompting Larry Summers, a former Obama economic
adviser, to offer a rating of his own.

“S&P’s track record has been terrible and its arithmetic is
worse,” Summers told CNN.

A pox on S&P’s house! Death to the messenger! In fact, the
messenger was shot so early and often one might have missed the
message amid all the gun smoke. Unless the U.S. gets its fiscal
house in order and aligns the promises it has made to retirees
with tax rates that don’t stunt growth, the nation’s sovereign-debt rating is unlikely to contain the first letter of the
alphabet at all.

Ready, Shoot, Aim

As it turns out, the sharpshooters were wide of the target.
S&P didn’t make an arithmetical error, as Summers would have us
believe. Nor did the sovereign-debt analysts show “a stunning
lack of knowledge,” as Treasury Secretary Tim Geithner claimed.
Rather, they used a different assumption about the growth rate
of discretionary spending, something the nonpartisan
Congressional Budget Office does regularly in its long-term
outlook.

CBO’s “alternative fiscal scenario,” which S&P used for its
initial analysis, assumes discretionary spending increases at
the same rate as nominal gross domestic product, or about 5
percent a year. CBO’s baseline scenario, which is subject to
current law, assumes 2.5 percent annual growth in these outlays,
which means less new debt over 10 years.

But S&P’s rating horizon is three to five years. The
difference between the two assumptions amounts to a gap of about
$250 billion in debt estimates for 2015: $14.5 trillion, or 79
percent of GDP, under the baseline scenario, versus $14.7
trillion, or 81 percent of GDP, under the alternative. (S&P
includes federal, state and local government debt in its
calculations.)

Over 10 years, the difference is, as Treasury says, $2
trillion and eight percentage points as a share of GDP.

Repeated Mistake

In its response to the S&P downgrade, Treasury used the
word “mistake” eight times, “error” five times, and other
pejorative words three times -- all in a 550-word memo. Just in
case anyone missed the point.

To be sure, S&P’s critics have legitimate gripes. Was the
credit rating company being too much of an activist in demanding
$4 trillion of savings for the U.S. in order to maintain its AAA
rating? Why didn’t S&P’s acceptance of a slower rate of spending
produce a different outcome? Was the downgrade political? If so,
is this a legitimate framework for assessing the
creditworthiness of the U.S.?

These are all valid questions. Yet when the discussions
between S&P and Treasury didn’t have the desired results, the
administration set out to discredit the messenger.

Cognitive Dissonance

Imperfect as that messenger may be, shooting him doesn’t
minimize the message. Fiscal policy is on an unsustainable path,
largely the result of entitlement spending exacerbated by the
retirement of the baby boomers. We have a government that lives
beyond its means and a political class that lacks the will to
find a solution.

For example, “preserving Medicare as we know it,” as House
minority leader Nancy Pelosi is wont to say, isn’t an option.
Medicare’s Hospital Insurance Trust Fund will be exhausted by
2024, according to the 2011 annual report from the program’s
trustees. That’s five years earlier than they projected in 2010.
Medicare has been running a cash-flow deficit, with expenditures
exceeding income, since 2008.

The Social Security Trust Fund, which ran a cash-flow
deficit excluding interest last year and is projected to run one
this year, will be exhausted in 2036. (No, Virginia, there is no
lockbox.)

‘Delicious Irony’

The Republicans’ intransigence on revenue increases, no
matter what the source, is another stumbling block. As economist
Art Laffer put it, “Who doesn’t want revenue increases” if they
result from stronger economic and job growth? Almost everyone
agrees the economy would get a boost from a more efficient tax
system that eliminates loopholes and lowers corporate and
individual income-tax rates.

Looking at the big picture, the American Enterprise
Institute’s Alex Pollock finds a “delicious irony” in the S&P
downgrade. The only reason it carried so much weight is the
federal government gave S&P that power. S&P is one of three
nationally recognized statistical rating organizations (NRSROs),
along with Moody’s and Fitch, designated by the SEC in 1975.

The Dodd-Frank financial-reform act includes a provision
that would end their monopoly, but progress on implementing it
has been slow.

In the meantime, just think if all the energy expended to
discredit S&P had been put to better use. Maybe the Obama
administration could have offered up its own plan to put the
U.S. on a sustainable fiscal path -- perhaps one that passes
muster with S&P.

(Caroline Baum, author of “Just What I Said,” is a
Bloomberg View columnist. The opinions expressed are her own.)